inflation


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It is ironic in a way that the Federal Reserve and its “rate hikes” have played a crucial role in setting back “reflation.”  There was some renewed hope up until that last FOMC vote in mid-March.  But since then, contrary to how markets “should” approach a higher federal funds band, bonds and funding have moved opposite. Swap spreads that for the first two and a half months of this year were decompressing, suggesting an easing in “dollar” pressure, began to compress (meaning for the 10s and 30s more negative) all over again after March 15.

It’s not difficult to assess why that was the case, where eurodollar futures, for example, could rise in price and therefore signal a (much) lower interest rate paradigm in the not-too-distant future despite the outwardly “hawkish” policy stance.  I wrote earlier this week:

“The markets ‘wanted’ the Fed exit to be the one that was described three years earlier, where ‘overheating’ was a more common term slipped consciously into policymaker speeches and media presentations. But the Fed only disappointed, with Janet Yellen at her press conference forced by less fawning questioning to admit, complete with the deer-in-headlights stare only she can give, that none of the models foresaw any uptick in growth whatsoever. Worse, the FOMC statement confirmed that though the CPI was nearly 3% at that moment, it was indeed going to be just a temporary artifact of oil price base effects, and that officially inflation was not expected to return to ‘normal’ until after 2019. Major, major buzzkill.”

In other words, as we have been saying all along, the Fed is exiting not because recovery is coming but because it never will.  There is, in their official judgment, nothing left for monetary policy to accomplish.  This pathetic economic condition, which they describe in their own way, through calculations like low or possibly negative R*, is now our baseline. What was unthinkable just three years ago (in the mainstream) is reality; ten years ago, it was plain impossible.

In January 2009, I wrote, “The economy is not likely to repeat the Japanese scenario.”  Unlike Japan, I reasoned, the American economy was far more dynamic and flexible, qualities that counterintuitively were on display at that very moment.  US businesses were laying off millions of workers every month, a horrible result for them but systemically what was necessary to restore profitability and cash flow.  Japan’s economy in the 1980’s and 1990’s was a contradiction of rigidity and a tangle of sclerosis, I thought, therefore its undoing and where the US would defeat the comparison.

Now so many years later, here the whole world sits in exactly the Japanese scenario.  Boy, was I wrong thinking that the Fed’s inability to affect the monetary system would be so easily set aside; or, if not so easily than overcome after enough time through good ol’ Americana.  I quite reasonably if naively assumed that faced with such incompetence on the policy level the far more dynamic American economy (which it was) would find its way out of that mess through other means. I had failed to appreciate the scale of the disaster on a longer timescale, how the eurodollar system had over the decades before entangled itself in everything here and everywhere else; and what that truly meant.

The most unambiguous and convincing evidence is how interest rates are low and have only remained that way no matter what, echoing what Milton Friedman wrote in 1963 about the 1930’s.  The issue cannot be business but money.

“The Federal Reserve repeatedly referred to its policy as one of ‘monetary ease’ and was inclined to take credit – and, even more, was given it – for the concurrent decline in interest rates, both long and short.”

He wrote again in the 1990’s warning the Japanese of the same condition, calling it the “interest rate fallacy” because though it is a clear sign of monetary tightness it is made unclear by economists who never seem able to understand money.  It’s a weird result for any central bank to be staffed with people who, at the top at least, can’t comprehend the nature of their own primary task.  It is far more so when it is a major central bank in a premier economy facing an historic liquidity situation.

It is downright criminal given the economic consequences of it, first Japan now the world.  The repeated situation strains all credibility, for the Japanese case was up to 2007 one of the most studied in all history.  How in the world could US (and European) officials end up making all the very same mistakes?

For one, US policymakers believed, in a way as I did, that they were superior to their Japanese counterparts.  In June 2003, the FOMC discussed these very scenarios and how the Bank of Japan was already at a place they increasingly believed they might have to follow.  QE had begun in March 2001 on that side of the Pacific, and was expanded after only a few months. In the US, the Federal Reserve had lowered the federal funds rate, what they believed was “stimulus”, even well more than a year after the official end of the dot-com recession.

By the start of summer in 2003, the short-term money rate was down to 1%, a level only a few years before that was thought beyond the pale of good monetary stewardship; so much so, that the gathered committee members at that meeting waxed philosophically about what they were doing, and even as Alan Greenspan contemplated what they really could do. The tone of that part of the discussion, centered on Japan and its experience at the zero lower bound that for the Fed had suddenly come into view, was “what if it’s us?”

“MR. KOHN.  Another problem in Japan was that the authorities were overly optimistic about the economy. They kept saying things were getting better, but they didn’t. To me that underlines the importance of our public discussion of where we think the economy is going and what our policy intentions are.”

That’s only true if you can be honest about it.  Japanese policy was only ever the same as American policy in that respect, for in all cases central banks believe they hold enormous power that given the will to use can only result in the preferred outcome.  Stimulus of the monetary type has been reduced to a tautology, or at best unchallenged circular logic; it works because it works. Or, as Ben Bernanke stated in his infamous “deflation” speech of November 2002:

“But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

He made that statement which was received without controversy as a technical matter; philosophically, he was criticized in the Weimar Germany kind of way without thinking it all the way through. A year before, the Federal Reserve, as well as the Bank of Japan I have to assume, had already found startling contrary evidence, at least as far as quantitative easing was concerned.  QE as an operative scheme is simple and straightforward; purchase assets from private banks so as to increase the level of bank reserves, therefore satisfying Milton Friedman’s supply critique. That was the same argument that Bernanke was echoing in 2002, to raise the money supply through whatever means so as to achieve what he claimed and therefore expected.

Mark Spiegel, an economist at the Federal Reserve Bank of San Francisco, had published in November 2001 an account of some already serious deficiencies observed in the effects of QE then ongoing in Japan.  As everyone expected as a matter of basic central bank math, Japan’s M1 that had sharply decelerated in its growth rate reversed course with the introduction of BoJ’s bond buying scheme expanding so-called base money.  But, as Spiegel detected, in the real world it wasn’t so simple and easy:

“While M1 has indeed enjoyed robust positive growth since the inception of the quantitative easing strategy, there has been a matching decline in the aggregate known as ‘quasi-money,’ which includes time deposits and a number of other less liquid assets. While the central bank can increase the stock of narrow money in the economy, the banks appear to be treating the exercise much like a swap of near-zero and zero interest rate assets, and they are responding with little change in their lending activities.”

The US and global banking system after 2007 has acted in the same way, as both Japanese banks in 2001 (and after) as well as American and European banks post-crisis did more than just what Spiegel had described. This liquidity “swap” was indeed far-reaching, eventually over time eroding balance sheet factors in any number of ways.  I have tracked gross notional derivative books as a proxy for this very behavior, which suggests that in truth the conditions of bank balance sheets and therefore money in Japan as everywhere else is worse than even Spiegel spelled out fifteen and a half years ago.

We are left with one, and only one, conclusion; Ben Bernanke was right that the Federal Reserve as the duly appointed US government agency is in possession of the printing press.  However, quantitative easing no matter how much academic gloss it is given is not it. Actual monetary conditions are determined by a myriad of other outside factors (relating exclusively to bank balance sheets) that appear impervious to QE-type strategies, a verdict rendered by sixteen years of experience in Japan and another eight in the US and elsewhere.

You could have made a quantitative case against QE in the Japanese or the first American instances, where the “Q” part was simply too small.  In the last five years in particular that factor has, too, been empirically eliminated, most especially by the Bank of Japan’s QQE reaching now half a quadrillion in yen reserves with the same results (none positive).

Why the Federal Reserve merely followed in BoJ’s footsteps for all these years is almost inexplicable; almost.  Again, going back to that meeting in June 2003, policymakers here knew it wasn’t working and Alan Greenspan began to wonder about his own capabilities.

“CHAIRMAN GREENSPAN.  What is useful, as has been discussed, is to build up our general knowledge so that when we are confronted with the need to respond with a twenty-minute lead time—which may be all the time we will have—we have enough background understanding to enable us to make informed decisions. We need to know how the system tends to work to be able to make the necessary judgments without asking one of our skilled technical practitioners to go off and run three correlations between X, Y, and Z. So I think the notion of building up our knowledge generally as a basis for functioning effectively is exceptionally important.”

Or, as I put it a year ago, make sure you can actually do what you say you can do before you have to do it.  The emphasis was in 2003 clearly on the “before you have to do it part” and largely because of how the Bank of Japan was executing a theoretically sound strategy that wasn’t producing the desired or expected results. But they never did that. The FOMC as well as most of the academic literature instead focused on BoJ’s execution of QE rather than the technical factors that were clearly suggesting (really proving) from the very beginning at the very least far more complexity in money than was assumed.

And so it brings the world back to repeating the Japanese mistakes, as Governor Kohn described them so many years ago, “They kept saying things were getting better, but they didn’t.”  The Fed was never honest in its assessment of what it really could do so that by the time D-day arrived for them they were arrogantly dismissive even of direct market contradictions (especially eurodollar futures that were in early 2007 correct and have remained so despite all the QE’s).  It wouldn’t have mattered if the FOMC had their skilled practitioners run off and do X, Y, and Z correlations, because X, Y, and Z were all based on the same mistaken premises, those of Ben Bernanke’s 2002 speech. Throughout the crisis period officials kept claiming “things were getting better” (subprime is contained) only to see the whole thing nearly collapse.  Afterward it was always the same, “things were getting better” (green shoots) even though QE1 was followed by a QE2, another global liquidity crisis, a QE3, a QE4, and then another global liquidity crisis.

How can even the most robust and dynamic economy move even slightly forward under those conditions?  That is another result we have over the last ten years fully tested and established; it can’t. Whatever the unobserved direct effects of monetary tightness, such outward and visible instability is another depressive factor all its own, and a very important one.

Because of one simple variable we have followed a path that a decade ago was believed literally impossible. Indeed, everything that has happened this last period had it been described to someone in 2005 would have sounded totally insane.  And there is only one factor capable of creating that situation, the one, tragically, most experts were the least concerned about. Life does have a habit of unfolding in that way, where the one thing you don’t expect is what kills you in the end. Call it the maestro’s curse, no conundrum required.

We aren’t yet dead, though we are now living in John Maynard Keynes’ long run.  Apologies to Dr. Keynes, it does matter, quite a bit actually.  Chaos, whether social or political, is the inevitable product of extended economic dysfunction.  People will put up with a lot, a large recession and even a sluggish recovery, but no people (the Japanese have committed to demographic suicide) will be able to withstand the social consequences of unceasing bleakness and no legitimate answers for it.  Such a condition offends all modern sense of human progress.

It is a testament to how far down we have gone, that in 2017 pleading with the Fed to just say it one more time, “things are getting better”, because that is all that is left standing between the comforting fiction and the cold reality of Japanification.  It could only have been a bitter blow, for the Fed in truth was up until now good for only that one thing, meaning optimism; carefully worded, of course, but in the end constant positivity about recovery even if always off just over the horizon. For many, that fiction was more meaningful than being led unwilling to the truth about a world without growth.

Thus, all hope is not extinguished, merely transposed to right where it belonged all this time.  Central bankers have said “listen to us because that is the only way for recovery”; only now to say instead, “listen to us because there is no recovery” as if nobody is allowed to notice the change.  We need only stop listening to economists altogether because they were wrong then and utterly so now.  The problem isn’t economics but economists, the former having been removed from the latter generations ago.

That is the great unappreciated truth about Japanification. It was never about zombie banks and asset bubbles, at least so far as separate issues from economists who know nothing, prove they know nothing, and then refuse to learn when all results show it. Nobody ever bothers to challenge a central banker about money because who would ever do such a thing?  It is such a thin façade, though, as once you move past it to do so is incredibly easy.  One need read only a single FOMC transcript from 2008 (and now 2011) to establish this.

As “reflation” hopes fade just as they did three years ago, how the world proceeds is a choice.  It is a collective one, but one that must be made nonetheless. We can allow nothing to ever change as the Japanese have.  The political situation in Japan has been upended several times over the past quarter-century, but what is the one thing that has remained constant no matter which side sits in power?  The Bank of Japan.  Republican or Democrat, what is the one thing that hasn’t changed in America?  Monetary policy that was and remains strangely devoid of any money.

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People in the West, certainly Americans, have long had a fascination with the East, with many predicting an inevitable “Asian century” marked by economic and market dominance. I have long disagreed with the consensus on China and other Asian Tigers, and others are beginning to agree. Many problems stand in the way of the “Asian century.”

Japan dazzled Westerners with the speed of its recovery from the ashes of World War II. Japanese purchases of U.S. trophy properties such as the Pebble Beach golf resort in California and Rockefeller Center in Manhattan in the 1980s, on top of the leaping property and equity prices in Japan, convinced many in the West that Japan would soon take over the world.

Japan’s economic decline in the early 1990s did not curb fascination with Asia. It simply shifted to the rapidly-growing developing economies, the Asian Tigers. The original four, Hong Kong, Singapore, South Korea and Taiwan, were later augmented by the likes of Malaysia, Thailand, the Philippines and, of course, China — and more recently, Pakistan, Vietnam, Indonesia and Bangladesh.

The late-1990s Asian financial crisis only temporarily disrupted Western fascination with the East and the prospects for an “Asian century.”

The 2007-2009 Great Recession and financial crisis ended rapid economic growth in Western countries and, therefore, the robust demand for exports that were the mainstay of developing economies. Still, Western zeal for Asia persisted and many, for no logical reasons, believed emerging countries could independently continue to grow rapidly and, indeed, support economic activity in the sluggish U.S. and Europe.

Chinese real economic annual growth rates nosedived from double digits to a recessionary 6.3 percent during the worldwide downturn, but then revived due to the massive 2009 stimulus program. Easy credit fueled a property boom and inflation, and excessive infrastructure spending replaced exports as the growth engine. As with the Asian Tigers earlier, many thought Chinese growth was self-sustaining and unrelated to ongoing sluggish economic performance in North America and Europe, especially after Chinese GDP topped Japan’s in 2009.

There are five main reasons why it won’t get any easier for Asia:

1. Globalization is largely completed. There isn’t much manufacturing in North America and Europe left to be moved to lower-cost developing economies. At the same time, the West is basically saturated with Asian exports, and those countries are competing fiercely among themselves for limited total export demand. Also, exports are shifting among those countries as low-end production moves from China to places such as Pakistan and Bangladesh, much as they shifted out of Japan in earlier decades. As economies grow, a greater share of spending is on services and less on goods. This reality is a long-term drag on almost all the other Asian lands, except India, due to their goods-export orientation. This will temper long-term growth for Asian goods exports even after rapid economic growth resumes in the U.S. and possibly other Western economies.

2. The shift from being export-led economies to ones driven by domestic spending, especially by consumers, has been slow. Chinese leaders want this transition, but it is moving at glacial speed. At 37 percent, Chinese consumer spending as a share of GDP is well below major developed countries such as the U.S. at 68.1 percent, Japan at 58.6 percent, and even Russia at 51.9 percent.

3. There are government and cultural restraints. Almost all developing Asian economies are tightly controlled by governments. Top-down regimes stoutly resist reform and often persist until they’re overthrown by revolutions. The current Mao dynasty in China, as I’ve dubbed it, seems seriously worried about popular unrest due to the lack of promised economic growth and is reducing what little political liberty was previously allowed. President Xi is now the Big Brother with lots of little brothers insuring proper thoughts and actions, even at the local level.

In Malaysia, Prime Minister Najib Razak is enmeshed in a multibillion-dollar investment scandal. In the Philippines, crime and drug trafficking are so rampant that President Rodrigo Duterte was elected on a platform of eliminating drug dealers, even by murderous vigilante squads. South Korea’s former president Park Geun-hye was thrown out over corruption.

4. Population problems endure. Despite the need for new workers in Japan as its population falls and ages, women are still discouraged from entering the labor force, and Japan continues to be unwelcoming toward newcomers. There’s no such thing as an immigration visa despite the fact that 83 percent of Japanese hiring managers have difficulty filling jobs, versus a global average of 38 percent in the last five years.

China also has a looming labor shortage and severe limits to economic growth due to its earlier one-child policy, which resulted in about 400 million Chinese not being born. Low fertility rates are also destined to reduce the populations of Hong Kong, Taiwan, Singapore and South Korea. At the other end of the population spectrum are Asian countries like Indonesia and India, whose population is expected to exceed China’s by 2022.

5. Military threats are growing in Asia, and could severely disrupt stability and retard economic growth if they flare up. China is exercising its military muscles by challenging U.S. military influence in the region by, among other actions, building military islands on reefs in the South China Sea. Japan is abandoning its post-World War pacifism and shifting from defensive to offensive capabilities. The Russians are also making military threats. The region contains five nuclear-armed countries: China, India and its rival Pakistan, Russia, and — most troubling — North Korea, which is testing long-range missiles. China isn’t happy about that, but it wants North Korea as a buffer between it and South Korea as well as a deterrent to its old foe, Japan.

The long-promised Asian Century of global leadership is unlikely to come to pass due to the completion of globalization, the slow shift from export-led to domestic-spending-driven economies, government and cultural restraints, aging and falling populations, and military threats.

The fascination with Asia started with Japan’s dazzling economic recovery after World War II, which culminated with purchases of U.S. trophy properties such as the Pebble Beach golf course and Rockefeller Center in the 1980s. Rising property and equity prices convinced many in the West that Japan would soon take over the world, but those bubbles burst in late 1989, sending the Nikkei index down 63 percent in less than three years and real estate prices down by 59 percent. Japanese economic growth has averaged just 1.1 percent since then.

With Japan’s decline, Western fascination shifted to the rapidly growing developing economies of the Asian Tigers, but the regional financial crisis that commenced in Thailand in 1997 started a domino-like collapse of neighboring financial markets and economies. With the 2007-2009 recession and financial crisis, export-led Asia suffered along with the economies of the U.S. and Europe. Yet Westerners didn’t abandon Asia, but shifted their admiration to China.

Chinese real economic annual growth rates nosedived from double digits to a recessionary 6.3 percent during the worldwide downturn, but then revived thanks to the huge 2009 stimulus program. Easy credit fueled a property boom and inflation, both of which were unwanted by Chinese authorities. Also, the growth in exports rebounded back to the 20 percent to 30 percent annual rates seen before the recession. As with the Asian Tigers earlier, many thought Chinese growth was self-sustaining and unrelated to ongoing sluggish economic performance in North America and Europe, especially after China’s gross domestic product topped Japan’s in 2009.

But like virtually all developing economies, China’s has been driven by exports that directly or indirectly are sold to North America and Europe. And those imports by the West are fundamentally curtailed by sluggish overall economic growth — the result of deleveraging, the working off of excess debt built up in the exuberant 1980s and 1990s. Annual Chinese export growth dropped from 20 percent to 30 percent in the 2000s to negative territory in February.

Further, globalization is largely completed, curbing that source of emerging-economy advance. And China’s huge total economic size had covered up its still-underdeveloped status. Even with the explosive growth in the past several decades, Chinese GDP per capita in 2016 was $8,030, or just 14 percent of the U.S.’s. Meanwhile, consumer spending in China amounts to just 37 percent of GDP compared to 68.1 percent in the U.S.

China won’t shrivel up and die, but it will be a much less important actor on the global stage as it shifts from commodity-munching exports, housing and infrastructure to consumer spending and services. The same was true of Japan starting in the early 1990s.

There may well be an “Asian Century,” but don’t hold your breath. It took about a millennium for the West to develop meaningful democracy, the rule of law, large middle classes that support domestic economies, and all the other institutions that are largely lacking in developing Asian lands at present.

5. Disinflation that started in 1980 continues with chronic deflation likely, especially as services follow goods in price retreats. The Federal Reserve and every other major central bank have a 2 percent inflation target. They don’t love inflation, which devastated economies and financial markets in the 1970s, when it rose to double-digit levels. But they fear deflation, which curbs consumer spending and capital investment along with economic growth as deflationary expectations set in. When price declines are widespread and chronic, buyers anticipate further declines so they wait for even lower prices. The resulting excess capacity and unwanted inventories force producers to cut prices further. Suspicions are confirmed, so buyers wait for still-lower prices in a self-perpetuating spiral. So deflation is self-feeding, as seen clearly for two decades in Japan.

Also, with deflation, the real cost of debts rises, making them harder to service and inducing financial problems and bankruptcies.

I remain convinced that widespread inflation results from overall demand exceeding supply, and deflation is caused by the reverse. Historically, governments create inflation in wartime with robust spending on top of fully-employed economies. That was the case in the late 1960s and 1970s, when Vietnam War outlays combined with War on Poverty spending. And that led to double-digit inflation rates by 1980. In peacetime, however, supply normally exceeds demand and deflation prevails. In the 96 years of war since 1749, wholesale prices rose 8.2 percent per year on average, but fell by 0.45 percent annually in the 170 years of peace. Assuming that the Trump administration, China, Russia and Middle East terrorists don’t drag the U.S. into a significant armed conflict, deflation is more likely in the years ahead, at least by historical precedent.

6. “The bond rally of a lifetime” that I first identified in 1981, when 30-year Treasuries yielded 15.2 percent, continues. With their safe-haven appeal, lower interest rates abroad and prospective deflation, we look for 2.0 percent yields on the long bond and 1.0 percent on the 10-year Treasury note.

I’ve been pretty lonely as a Treasury bond bull for 36 years. Stockholders and others may hate them, but their quality is unquestioned, and Treasuries and the forces that move yields are well-defined: Federal Reserve policy and inflation or deflation.

In addition, I’ve always liked Treasury coupon and zero-coupon bonds because of their three sterling qualities. First, they have gigantic liquidity with hundreds of billions of dollars’ worth trading each day. So all but the few largest investors can buy or sell without disturbing the market.

Second, in most cases, they can’t be called before maturity. This is an annoying feature of corporate and municipal bonds. When interest rates are declining and you’d like longer maturities to get more appreciation per given fall in yields, issuers can call the bonds at fixed prices, limiting your appreciation. Even if they aren’t called, callable bonds don’t often rise over the call price because of that threat. But when rates rise and you prefer shorter maturities, you’re stuck with the bonds until maturity because issuers have no interest in calling them. It’s a game of heads the issuer wins, tails the investor loses.

Third, Treasuries are generally considered the best-quality issues in the world. This was clear in 2008 when 30-year bonds returned 42 percent, but global corporate bonds fell 8 percent, emerging market bonds lost 10 percent, junk bonds dropped 27 percent, and even investment-grade municipal bonds fell 4 percent in price.

Treasuries sold off with the “Trump Trade” after his election, but revived recently. This reflects deflation prospects since inflation rates and Treasury yields move together — up in the post-World War II years up until 1980 and then down ever since. Treasuries have also rallied lately due to their safe-haven status and thanks to having a higher yield than other developed country sovereigns, making them more attractive to foreign investors.

 

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In the article “Rapid money supply growth does not cause inflation” written by Richard Vague at the Institute for New Economic Thinking, December 2, 2016, the author argues that empirical evidence shows that increases in money supply has nothing to do with inflation. According to Vague,

Monetarist theory, which came to dominate economic thinking in the 1980s and the decades that followed, holds that rapid money supply growth is the cause of inflation. The theory, however, fails an actual test of the available evidence. In our review of 47 countries, generally from 1960 forward, we found that more often than not high inflation does not follow rapid money supply growth, and in contrast to this, high inflation has occurred frequently when it has not been preceded by rapid money supply growth.

Now Vague defines inflation as, three or five consecutive years of increases in the consumer price index (CPI) of 5% or more. Based on this he has concluded that an increase in the money supply does not cause inflation.

The main problem here is that inflation is not changes in prices but rather changes in money supply. The fact that Vague could not find strong correlation between increases in money supply M2 and changes in the CPI does not prove much.

To begin with the price of a good is the amount of dollars paid for the good. If the growth rate of money is 5% and the growth rate of goods is also 5% then there will not be any increase in the prices of goods. If one were to follow that inflation is the increase in the CPI then one will conclude that despite the increase in money supply by 5% inflation is 0%.

However, if we were to follow the definition that inflation is about increases in the money supply then we will conclude that inflation is 5%.

So how are we to decide about the correct definition of inflation? Is it about increases in the money supply or increases in prices?

The Essence of Inflation

The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are. To define a thing we need to go to the origin of how it has emerged.

Historically inflation originated when a country’s ruler such as the king would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this Rothbard wrote,

More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks,” but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.

On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a diluted gold coin.

The increase in the number of coins brought about by the dilution of gold coins is what inflation is all about.

Note that what we have here is an inflation of coins, i.e., an expansion of coins. As a result of inflation, the ruler can engage in an exchange of nothing for something (he can engage in an act of diverting resources from citizens to himself).

Under the gold standard, the technique of abusing the medium of exchange became much more advanced through the issuance of paper money un-backed by gold. Inflation therefore means an increase in the amount of receipts for gold on account of receipts that are not backed by gold yet masquerade as the true representatives of money proper, gold.

The holder of un-backed receipts can now engage in an exchange of nothing for something. What we have is a situation where the issuers of the un-backed paper receipts divert real goods to themselves without making any contribution to the production of goods.

In the modern world money proper is no longer gold but rather paper money; hence inflation in this case is an increase in the stock of paper money.

Observe that we don’t say as monetarists are saying that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

If we were to accept that inflation is increases in the money supply then we will reach the conclusion that inflation results in the diversion of real wealth from wealth generators toward the holders of newly printed money. We will also reach the conclusion that monetary pumping, i.e., inflation is bad news for the wealth generating process. No empirical study is required to confirm or to refute this.

As we have shown in the example at the beginning increases in the money supply need not always to be followed by general increases in prices. Prices are determined by both real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant, prices might display low increases.

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The federal debt has gone from astounding to unbelievable to incomprehensible, a new problem has emerged: The US government is actually running out of places to borrow.

How Many Zeros Are in a Trillion?

The $20 trillion debt is already twice the annual revenues collected by all the world’s governments combined. Counting unfunded liabilities, which include promised Social Security, Medicare, and government pension payments that Washington will not have the money to pay, the federal government actually owes somewhere between $100 trillion and $200 trillion. The numbers are so ridiculously large that even the uncertainty in the figures exceeds the annual economic output of the entire planet.

Since 2000, the federal debt has grown at an average annual rate of 8.2%, doubling from $10 trillion to $20 trillion in the past eight years alone. Who loaned the government this money? Four groups: foreigners, Americans, the Federal Reserve, and government trust funds. But over the past decade, three of these groups have cut back significantly on their lending.

Foreign investors have slowed the growth in their lending from over 20% per year in the early 2000s to less than 3% per year today. Excluding the Great Recession years, American investors have been cutting back on how much they lend the federal government by an average of 2% each year.

The Fed is the only game left in town.

Social Security, though, presents an even bigger problem. The federal government borrowed all the Social Security surpluses of the past 80 years. But starting this year, and continuing either forever or until Congress overhauls the program (which may be the same thing), Social Security will only generate deficits. Not only is the government no longer able to borrow from Social Security, it will have to start paying back what it owes – assuming the government plans on making good on its obligations.

With federal borrowing growing at more than 6% per year, with foreign and American investors becoming more reluctant to lend, and with the Social Security trust fund drying up, the Fed is the only game left in town. Since 2001, the Fed has increased its lending to the federal government by over 11% each year, on average. Expect that trend to continue.

Inflation to Make You Cry

For decades, often in word but always in deed, politicians have told voters that government debt didn’t matter. We, and many economists, disagree. Yet even if the politicians were right, the absence of available creditors would be an insurmountable problem—were it not for the Federal Reserve. But when the Federal Reserve acts as the lender of last resort, unpleasant realities follow. Because, as everyone should be keenly aware, the Fed simply prints the money it loans.

A century of arguing about how much to increase spending has left us with a debt that dwarfs the annual economic output of the planet.

A Fed loan devalues every dollar already in circulation, from those in people’s savings accounts to those in their pockets. The result is inflation, which is, in essence, a tax on frugal savers to fund a spendthrift government.

Since the end of World War II, inflation in the US has averaged less than 4% per year. When the Fed starts printing money in earnest because the government can’t obtain loans elsewhere, inflation will rise dramatically. How far is difficult to say, but we have some recent examples of countries that tried to finance runaway government spending by printing money.

From 1975 to 1990, the Greek people suffered 15% annual inflation as their government printed money to finance stimulus spending. Following the breakup of the Soviet Union in the 1990s, Russia printed money to keep its government running. The result was five years over which inflation averaged 750%. Today, Venezuela’s government prints money to pay its bills, causing 200% inflation which the International Monetary Fund expects to skyrocket to 1,600% this year.

For nearly a century, politicians have treated deficit spending as a magic wand. In a recession? We need jobs, so government must spend more money! In an expansion? There’s more tax revenue, so government can spend more money! Always and everywhere, politicians argued only about how much to increase spending, never whether to increase spending. A century of this has left us with a debt so large that it dwarfs the annual economic output of the planet. And now we are coming to the point at which there will be no one left from whom to borrow. When creditors finally disappear completely, all that will remain is a reckoning.

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Inflation isn’t dead; it just might not be where you think it is.

To find significant price increases, you need only look in the right places. There are many goods and services with rising prices, as well as those without. Together, they tell a fascinating tale about the modern global economy. Understanding the forces driving prices higher — or not — is crucial to investors and policy makers alike.

Given that the Federal Reserve has been trying to generate inflation for much of the past decade, the significance of the distribution is both important and telling. Why some prices are rising at twice the median rate of general inflation is worth delving into.

Look at the chart below: it show specific categories of goods and services versus the entire basket of goods and services that makes up the consumer price index.

*see below

Source: American Enterprise Institute

Let’s look a little more deeply at each category.

Textbooks:  The industry operates as a quasi-monopoly. A student assigned a given text book doesn’t have much choice. The rise of used-book exchanges provided some competition, but the publishers merely issue revised editions that are neither new nor improved. Inflation here is a function of rentier capitalism. Note that other kinds of books have fallen in price during the same period.

College Tuition: Blame demographics, guaranteed student loans and administrative bloat. The baby boomers’ kids created many more potential college students than there were seats, leading to an imbalance in demand and supply. Responses varied from adding more professors to expanding class sizes to opening new schools.

But most schools responded by raising tuition.

And students paid. The Federal Reserve Bank of New York and theNational Bureau of Economic Research looked at increases in student borrowing, funded largely through federal student-loan programs. There is a good argument to be made that this is what has drivenmuch of the increase in college tuition.

Medical Care: The bottom line in the relentless rise in health-care costs is that market forces don’t work very well in this industry. This is why every modern industrialized country, except the U.S., has a single-payer government option or something like it. Even worse, the drug industry has persuaded Congress to bar government-run health programs from negotiating lower prices.

Food and Beverages: Prices for milk, beef and most other foodstuffs soared in the 2000s, as the U.S. dollar lost 41 percent of its value (many commodities are priced in dollars) and commodity prices soared.

Housing: During the 2000s housing boom, when lending standards evaporated, home prices went up two and three times their normal rates. But the Bureau of Labor Statistics had the cost of housing as falling. Why? The BLS uses something called owner’s equivalent rent, and it tends to give false reads on housing prices.

When more people are buying and driving up home prices, it means less demand for rental units, leading to lower prices. During the housing bust circa 2006-2011, they showed the opposite. Fewer buyers meant more renters, and so rental price gains were robust.  I don’t know the best way to gauge real estate prices, but tracking owners’ equivalent rent creates a distortion.

Toys: Manufacturing has been outsourced to lowest cost parts of world, hence prices have plummeted.

Wireless Services, Software, TVs: Technology prices benefit from two key factors: the technology adoption lifecycle and manufacturing economies of scale. The long and short of it is that as new products enter the mass market  they move down the unit-cost scale, from quirky one-off devices to cheap commodity goods. Think about the first flat screen televisions at more than $10,000 plus; versions that are as good or better than those now cost $500.

So what might we conclude from looking at the chart’s component parts? Maybe only that it’s a little easier to see why the Fed has been having a hard time getting inflation to rise. While some prices are indeed up, many powerful forces have driven other prices lower — and these are forces that the Fed can’t easily influence. Until there is a substantial and sustained increase in wages (or a huge drop in the dollar), inflation may very well remain below the Fed’s 2 percent target for a long time to come.

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James Grant, Wall Street expert and editor of the investment newsletter «Grant’s Interest Rate Observer», warns of a crash in sovereign debt, is puzzled over the actions of the Swiss National Bank and bets on gold.

From multi-billion bond buying programs to negative interest rates and probably soon helicopter money: Around the globe, central bankers are experimenting with ever more extreme measures to stimulate the sluggish economy. This will end in tears, believes James Grant. The sharp thinking editor of the iconic Wall Street newsletter «Grant’s Interest Rate Observer» is one of the most ardent critics when it comes to super easy monetary policy. Highly proficient in financial history, Mr. Grant warns of today’s reckless hunt for yield and spots one of the biggest risks in government debt. He’s also scratching his head over the massive investments which the Swiss National Bank undertakes in the US stock market.

About James GrantJames Grant, financial journalist and historian, is the founder and editor of «Grant’s Interest Rate Observer», a twice-monthly journal of the investment markets and must read for financial professionals. A former Navy gunner’s mate, he earned a master’s degree in international relations from Columbia University and began his career in journalism in 1972, at the Baltimore Sun.

He joined the staff of Barron’s in 1975 where he originated the «Current Yield» column. Mr. Grant is the author of several books covering both financial history and biography. His latest book, «The Forgotten Depression: 1921 – The Crash That Cured Itself», was published at the end of 2014. Mr. Grant is a 2013 inductee into the Fixed Income Analysts Society Hall of Fame. He is a member of the Council on Foreign Relations and a trustee of the New-York Historical Society. He and his wife live in Brooklyn. They have four grown children.Jim, for more than three decades Grant’s has been observing interest rates. Is there anything left to be observed with rates this low?


Interest rates may be almost invisible but there is still plenty to observe. I observe that they are shrinking and that the shrinkage is causing a lot of turmoil because people in need of income are in full hot pursuit of what little of yields remains.

What are the consequences of that?
It reminds me of the great Victorian English journalist Walter Bagehot. He once said that John Law can stand anything but he can’t stand 2%, meaning that very low interest rates induced speculation and reckless investing and misallocation of capital. So I think Bagehot’s epigraph is very timely today.

John Law was mainly responsible for the great Mississippi bubble which caused a chaotic economic collapse in France in the early 18th century. How is the story going to end this time?
It will turn out to be very bad for many people. If Swiss insurance and reinsurance executives are reading this right now they might be rolling their eyes and they might be frustrated to hear an American scolding from a distance of 3000 miles about the risk of chasing yield. After all, if you’re in the business of matching long term liabilities with long term assets you have little choice but to wish for a better, more sensible world. But you have to take the world as it is and today’s world is barren of interest income. The fact is, that these are very risk fraught times.

Where do you see the biggest risks?
Sovereign debt is my nomination for the number one overvalued market around the world. You are earning nothing or less than nothing for the privilege of lending your money to a government that has pledged to depreciate the currency that you’re investing in. The central banks of the world are striving to achieve a rate of inflation of 2% or more and you are lending certainly at much less than 2% and in many  cases at less than nominal 0%. The experience of losing money is common in investing. But where is the certitude of loss even before your check clears? That’s the situation with sovereign debt right now.

On a worldwide basis, more than a third of sovereign debt is already yielding less than zero percent.
There is not quite a bestseller, but a very substantial book called «The History of Interest Rates». It was written by Sidney Homer and Richard Sylla. Sidney Homer is no longer with us, but Richard Sylla is alive and well at New York University. So I called him and said: « Richard, I’ve read many pages but not every single page in your book which traces the history of interest rates from 3000 BC to the present. Have you ever come across negative bond yields?» He said no and I thought that would be kind of a major news scoop: For the first time in at least 5000 years we have driven interest rates below the zero marker. I thought that was an exceptional piece of intelligence. But I notice however that nobody seems to have picked up on it.

It’s now already two years ago since the ECB was the first major central bank to introduce negative rates.
There are some other historical settings: In Europe, Monte dei Paschi di Siena, this 500 and plus year old bank in Italy, is struggling and as broke as you can be without being legally broke. Monte dei Paschi has survived for half a millennium and now it is on the ropes. Meanwhile, the Bank of England is doing things today that it has never done in its history which is 300 plus years. So I suggest that these are at least interesting times and in many respects unprecedented ones.

So what’s the true meaning of all this?
In finance, mostly nothing is ever new. Human behavior doesn’t change and money is a very old institution and so are our markets. Of course, techniques evolve, but mostly nothing is really new. However, with respect to interest rates and monetary policy we are truly breaking new ground.

Now central bankers are even talking openly about helicopter money. Will they really go for it?
I already hear the telltale of beating rotor blades in the sky. I also hear the tom-toms of fiscal policy being pounded. There seems to be some kind of a growing consensus that monetary policy has done what it can do and that what me must do now – so say the «wise ones» – is to tax and spend and spend and spend. That seems to be the new big idea in policy. In any case, it is not good for bondholders.

Interestingly, nobody seems to be talking about the growing government debt anymore. Also, budget politics are just a side note in the ongoing presidential elections.
The trouble with this election is that somebody has to win it. I have no use for Donald Trump but I have equally no use for Hillary Clinton. The point is that one of those two is going to win. That is the tragedy! So we at Grant’s regret that one of them is going to win.

The financial crisis and the weak economic recovery likely have spurred the rise of Donald Trump. Why isn’t the US economy in better shape after all those monetary programs?
I wonder how it would have been if markets had been allowed to clear and if prices had been allowed to find their own level in real estate in 2008. Central banks have intervened to quell financial panics for at least 200 years. For instance, in 1825 the bank of England lent without stint and was not – as they said – overnice about the kind of collateral. That was a very dramatic intervention. So it’s not as if we have never before seen the lender of last resort at work. But what is new is the medication of markets through this opiate of quantitative easing year after year after year following the financial crisis. I think that this kind of intervention has not only not worked but it has been very harmful. Around the world, the economies are not responding despite radical monetary measures. To some degree, I believe,  they are not recovering because of radical monetary measures.

What’s exactly the problem with the US economy?
There is another side of what we are seeing now: In America certainly the Federal Reserve and bank regulators generally are very heavy handed in their interventions. I’m sure they have every good intention. But with their regulatory charges they are suppressing the recovery in credit that takes place  in a normal economic recovery and in this particular case after a depression or after a liquidation.

Then again, a revisit of the financial crisis would be catastrophic.
The new rules with respect to financial reform have absorbed not only forests worth of paper but also the time and attention of legions of lawyers. If you talk to a banking executive what you hear is that the banks have been overwhelmed by the need to hire compliance and regulatory people. This is especially bearing on the smaller banks. I think that’s part of the story of the lackluster recovery: Monetary policy has been radically open in the creation of new credit. But it has been radically restrictive with regard to risk taking in the private world.

So what should be done to get the economy back on track?
There are guides in history on how to do this. For more than a hundred years in Britain, in the United States and probably as well in Switzerland, the owners of the equity of a bank themselves were responsible for the solvency of the bank. If the bank became impaired or insolvent they had to stump up more capital to pay off the liability holders, including the depositors. But over the past hundred years collective responsibility in banking has gradually replaced individual responsibility. The government, with the introduction of deposit insurance, new regulations and interventions has superseded the old doctrine of the responsibility of the owners of a property. That’s why I think we need to go away from government intervention and go more towards market oriented solutions such as the old doctrine of responsibility of the bank owners.

At least in the US, the Fed is trying to go back to a more normal monetary policy. Do you think Fed chief Janet Yellen will make the case for another rate hike at the Jackson Hole meeting next week?
Janet Yellen is by no means an impulsive person. According to the « Wall Street Journal», she arrives for a flight at the airport hours early – and that’s plural! So this is a most deliberative and risk averse person. Also, as a labor economist, she’s a most empathetic person. She believes what most interventionist minded economists believe: They have very little faith in the institution of markets and they don’t believe that the price mechanism is anything special. They want to normalize rates and yet they can always find an excuse for not doing so. We have been hearing for years now that the next time, the next quarter, the next fiscal year they will act. So I believe what I’m seeing: None of these days the Federal Funds Rate will go higher than 0.5%. I can’t see that happening.

Wall Street seems to think along the same lines. So far, many investors don’t take the renewed chatter of a rate hike too seriously.
The Fed is now hostage to Wall Street. If the stock market pulls back a few percent the Fed becomes frightened. In a way I suppose, the Fed is justified in that belief because it is responsible to a great degree for the elevation of financial asset values. Real estate cap rates are very low, price-earnings-ratios of stocks  are very high and interest rates are extremely low. One can’t be certain about cause and effect. But it seems to me that the central banks of the world are responsible for a great deal of this levitation in values. So perhaps they feel some responsibility for letting the world down easy in a bear market. It has come to a point where the Fed is virtually a hostage of the financial markets. When they sputter, let alone fall, the Fed frets and steps in.

Obviously, the financial markets like this cautious mindset of the Fed. Earlier this week, US stocks climbed to another record high.
Isn’t that a funny thing? The stock market is at record highs and the bond market is acting as if this were the Great Depression. Meanwhile, the Swiss National Bank is buying a great deal of American equity.

Indeed, according to the latest SEC filings the SNB’s portfolio of US stocks has grown to more than $60 billion.
Yes, they own a lot of everything. Let us consider how they get the money for that: They create Swiss francs from the thin alpine air where the Swiss money grows. Then they buy Euros and translate them into Dollars. So far nobody’s raised a sweat. All this is done with a tab of a computer key. And then the SNB calls its friendly broker – I guess UBS – and buys the ears off of the US stock exchange. All of it with money that didn’t exist. That too, is something a little bit new.

Other central banks, too, have become big buyers in the global securities markets. Basically, it all started with the QE-programs of the Federal Reserve.
It is a truism that central banks do this. They’ve done this of course for generations. But there is something especially vivid about the Swiss National Bank’s purchases of billions of Dollars of American equity. These are actual profit making, substantial corporations in the S&P 500. So the SNB is piling up big positions in them with money that really comes from nothing. That’s a little bit of an existential head scratcher, isn’t?

So what are investors supposed to do in these bizarre financial markets?
I’m very bullish on gold and I’m very bullish on gold mining shares. That’s because I think that the world will lose faith in the PhD standard in monetary management. Gold is by no means the best investment. Gold is money and money is sterile, as Aristotle would remind us. It does not pay dividends or earn income. So keep in mind that gold is not a conventional investment. That’s why I don’t want to suggest that it is the one and only thing that people should have their money in. But to me, gold is a very timely way to invest in monetary disorder.

 

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Trump previously discussed defaulting on US debt. It of course wouldn’t be the first time, Roosevelt in 1933 in confiscating gold, defaulted.

Nixon in 1971 again defaulted, through, once again gold.

Inflation is of itself a default. Inflation has been a constant issue since the default in 1933 and will continue to be a default.

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